Inflation Need Not Cause Unemployment - Research Paper Example

Inflation Need Not Cause Unemployment Introduction Professional debate over the relationship between unemployment and inflation has been intertwined with controversy about the relative role of monetary, fiscal, and other factors affecting aggregate demand. One of these issues deals with how a change in aggregate demand, however produced, works itself out through changes in employment and general price levels. The others however deal with factors accounting for the changes in aggregate nominal demand. On close inspection, one can see that these issues are closely inter related. The effects of a change in aggregate nominal demand on employment and price levels may not be independent of the sources of the change being studied, and conversely the effects of monetary, fiscal, or other sources of change in the aggregate nominal demand may depend upon how employment and price levels react. While analyzing, clearly these two issues are to be dealt with together1. In the last few decades of economic development, professional views have gone through two stages while discussing the relationship between inflation and unemployment. The first was accepting a suitable trade- off in the form of the Phillip’s Curve, and the second was the introduction of inflation expectations, as a variable shifting in the short- run Phillip’s Curve, and the acceptance of a natural rate of unemployment, as determining the position of a vertical long- run Philip’s Curve2. Research Methodology and Limitations of Research I basically conducted secondary research, referring to articles published in journals as they are supposed to authentic. I borrowed from them their models and their methods of analysis. First of all, I explained the Phillip’s Curve which is used as the primary basis for explaining the causal link between inflation and unemployment. Next, I criticize the model borrowing from noted economists. I then offer alternative models for analysis like the Laffer- Ranson Model discussed at a great length by MacRae. Next I discuss the limitations of the Phillip’s Curve as discussed by MacRae, Benoit and Holmes to show that inflation does not always lead to unemployment. Since I rely on secondary research, the models shown are those predicted by other economists. Such research is done by studying intensive history of various economies. The data and results they show are accurate although some economists do negate them. I, however, do not discuss this negation. Aim of the Research The basic aim of this research is to negate the general concept that most economists hold that inflation and unemployment have a causal relationship. This is usually reaffirmed by the Phillip’s Curve which is much studied. I refute this argument and claim that high levels of inflation do not always lead to unemployment. The Phillip’s Curve The main theoretical basis of the Phillip’s Curve has been provided by Lipsey, who derived the negatively sloping relationship between the rate of change of money wage rates and unemployment by relating the rate of money wage rates to excess demand or supply of labor and using unemployment as a measure of that excess demand or supply3. The Phillip’s Curve shows a statistically inverse relationship between the rate of inflation and unemployment as already stated above. Essentially, when the rate of unemployment is high, the inflation rate is low and when the rate of unemployment is low, the rate of inflation is high. Modern policy makers have built their church on this hypothesis. Disagreements occur mainly over at what point the trade- off should be made4. Given that the trade- offs between employment and the general price levels are highly significant and a necessary building block of business cycle theory, economists are yet to find completely satisfactory or ample explanations for them. Most central bankers and monetary economists have come to the consensus that a contractionary monetary shock raises unemployment, at least temporarily, and leads to a delayed and gradual fall in inflation. Contrastingly, standard dynamic models of price adjustment cannot explain this pattern of responses. Reconciling the consensus views about the effects of monetary policy with models of price adjustments still remain a puzzle for business cycle theorists. This trade- off is inexorable as it is impossible to make sense of the business cycle, and in particular, the short- run effects of monetary policy, unless we admit the existence of a trade- off between inflation and unemployment. Also, this trade- off remains mysterious in the sense that the economics profession is yet to produce a satisfactory theory to explain it5. Critique of the Phillip’s Curve According to Mankiw, this trade off does not imply a scatter plot of the two variables producing the standard negatively sloped Phillip’s Curve, nor does it imply a particular regression fitting the data well and producing any particular set of coefficients. He states, that the inflation- unemployment trade- off, at its very core, is a statement of monetary economics which claims that changes in monetary policy forces these two variables to move in opposite directions. This is because, as Hume pointed out two centuries ago, monetary policy affects both nominal variables such as inflation and real variables such as unemployment. But economists have yet to come up with a convincing, plausible theory to explain these changes6. Central bank independence, the degree of centralization of wage bargaining and the interaction between these institutional variables, on real wages, unemployment and inflation, exist in a framework in which unions are averse to inflation. This aversion moderates union’s wage demands as they attempt to induce the Central Bank to inflate at a lower rate. An increase in the degree of centralization of wage bargaining, and essentially a decrease in the number of unions, causes two opposite effects on real wages, unemployment and inflation. It reduces the substitutability between the labor of different unions and therefore the degree of effective competition between them. This ‘reduced competition effect' causes a raise in the real wages, unemployment and inflation. But the decrease in the number of unions also strengthens the moderating effect of inflationary fears on the real wage demands of each union. This ‘strategic effect' leads to the lowering of real wages, unemployment and inflation7. An important implication of classical monetary economic theory is that, if fully expected and adjusted to, the rate of inflation cannot have an influence on real economic activity. In the context of the Phillip’s Curve, this basic, classical conclusion has been recently reestablished by economic writers such as Mortensen and Phelps. In their view, any trade off that may exist between unemployment and inflation must be because of adjustment lags, money illusion, and similar frictions which disappear in the long- run equilibrium. Only one rate of unemployment namely, the natural rate of unemployment is compatible with a constant rate of inflation. Any such attempts by governments to attain a higher or lower rate of unemployment using ordinary fiscal or monetary techniques would inevitably result in ever increasing rates of inflation or deflation. The mechanism through which the Phillip’s Curve becomes unstable is the generation of and adjustment to inflationary expectations. Even though there seems no obvious fault with the logic of this line of thinking of the classical economists, the empirical evidence on the matter in which expectations are generated and adjusted to be is not very strong8. Monetary policies are designed in a certain manner to achieve two primary objectives: firstly, to ensure that macroeconomic variables like output and employment are adequately stabilized in response to exogenous shocks; and secondly, to avoid giving incentives for the creation of average inflation above the socially desirable level, called as the inflation bias, to the monetary authority. These two objectives can be reconciled if the monetary authority can be offered a contract where its monetary reward is a function of the inflation: an inflation contract. This inflation contract can be designed in such a way that the monetary policy rule chosen by the Central Bank is consistent with optimal stabilization and eliminates an inflation bias. When Central Bank and the government’s preferences over inflation are the same, the payment specified in the contract is a linear function of inflation, called as a linear inflation contract. This can be analyzed using the simple Barro- Gordon model of inflation, where the economy is described by a ‘surprise’ supply function, and the government has a quadratic loss function defined over output and inflation9. Given the time path and the expected levels of inflation, the time path of the actual rate of inflation can also be derived10. According to Lockwood, it is always possible to come up with a design of a linear inflation contract that will ensure that in the intuitive equilibrium, the inflation rule chosen by the monetary authority or the Central Bank is the government’s pre- commitment rule. The main feature of the contract is that the penalty for an increase in the rate of inflation must depend on lagged unemployment, and does so counter- cyclically: that is, the higher the rate of unemployment prevailing in the last period, the greater the penalty. However, there is also a contrasting result; it is virtually impossible to choose a contract that will achieve the government’s pre- commitment inflation rule should the other equilibrium, which Lockwood refers to as the non- intuitive equilibrium, comes about. Moreover, it is also possible to show under some set conditions, that the optimally designed contract for the intuitive equilibrium can make the non- intuitive equilibrium worse in terms of welfare from the government’s point of view that no contract at all11. As stated above, the inflation equations including the levels of unemployment but not taking into account money growth can be improved if changes in unemployment are considered. Because inflation is affected by unemployment and money growth, inflation’s response to monetary stimulus to reduce unemployment is faster than the response implied by pure unemployment- inflation models but slower than the response implied by pure money growth- inflation models12. The Laffer- Ranson Model The Laffer- Ranson model shows a striking conclusion regarding the relationship between inflation and unemployment. The evidence that it presents does not show a substantial amount of partial relationship between the rate of change of the GNP price deflator and the rate of change of unemployment. These results do not support the existence of a Phillip’s Curve. While there is no explicit relationship between the rate of change of the GNP price deflator and the rate of change of unemployment in the model, an implicit one does exist with the rate of change of money stock being the connecting link. The endogenous variables that the Laffer- Ranson model deals with are nominal GNP, the GNP price deflator, the unemployment and real GNP. The exogenous variables of the model are the conventional money supply, federal government purchases of goods and services, a measure of the proportion of lost man- hours lost during the event of strike, Standard and Poor’s composite index of common stock prices, and the market yield on thirteen week treasury bills. In addition there are also three seasonal dummy variables corresponding to the three quarters of the year13. Although there is no direct relationship between the change in the GNP price deflator and the rate of unemployment in the Laffer- Ranson model, there does exist an indirect change since the change in the money supply affects both the variables. There is a short- run trade- off between the inflation rate and the change in the unemployment rate associated with the use of the monetary policy. According to most monetary economists, there is a natural rate of unemployment so that in the long run it is possible using aggregate demand policy to reduce the rate of unemployment below the natural rate without accepting an accelerating rate of inflation. Hence, there is no long run trade- off between the inflation rate and the unemployment rate, but there is one between the change in the inflation rate and the unemployment rate14. There exists an unusual relationship between unemployment and the rate of inflation in the Laffer- Ranson model. The price equation of the model includes the change in the supply of money, which corresponds to the change in demand pressure, but excludes the unemployment rate, which acts as a proxy for the level of demand pressure. Hence there is a short run trade off between unemployment and inflation associated with monetary policy, but there is no long run trade- off in the model. In the long run, the Laffer- Ranson model implies that there is a natural rate of inflation which is a function of the interest rate. Hence, simply including a monetary variable in the price equation does not imply a monetarist view of inflation, which is that there is a natural rate of unemployment15. Limitations of the Phillip’s Curve The familiar model of demand and supply for labor does not provide a functional relationship between the operational concept of unemployment and excess demand and supply using the Phillip’s Curve analysis provided by Holmes and Smyth. Therefore, a relationship between the rate of change of money wage rates and the rate of unemployment cannot be derived from this model hence the Lipsey type of theoretical justification for the Phillip’s Curve phenomena is not valid16. The Phillip’s Curve certainly does have some statistical basis and charts a genuine, but by no means accurate, relationship of varying intensity between the rate of unemployment and the rate of inflation which has been observed in certain countries in certain historical periods. Nonetheless the statistical base is somewhat weak to carry out such an immense policy load. Economists are not sure within what range of variation it will the relationships it shows remain, nor for how long. Furthermore, it simply charts a relationship but does it explain it. Also, some of the institutional forces that may have been responsible for temporarily creating that relationship may now be on the verge of breaking down. For instance, as strike breaking is becoming institutionally less feasible, and as trade unions are becoming more strongly organized with increasing political influence and power, they are becoming less and less deterred from striking to achieve wage increases even during periods of heavy unemployment17. One can clearly see that since the 1950s, the cost of living in the world has risen every year even in periods of recession and when raw material costs have declined. Hence, recession and unemployment can no longer effectively halt inflation, but at most can only attempt at slowing it down. Also, recently new forces seem to be at work giving a rather explosive quality to inflation: inflation has been on the rise despite increasing levels of unemployment, especially in the United States, since the Great Depression. Hence, the Phillip’s Curve is showing only a part of the story, ignoring a large part of the truth. The simplistic Phillip’s Curve approach shows that the only way to stop inflation is to create a great deal of slack in the economy by means of tightening the money supply and drastically cutting government spending. This has led to significant increases in the rates of interest. This did indeed lead to a slack but output decreased as a result of which unemployment rose in the United States. But the general price level kept rising. The existence of major recession and violent inflation at the same time, points to a basic weakness in the whole theory18. The aim of these deflationary policies is to cut the total spending taking into account the classical notion that if inflation is too much money chasing too few goods, then by reducing the amount of money chasing goods, one is bound to bring inflation under control. The fact that is not recognized is that if goods are produced only in order to be sold, then if one cuts back the size of the markets one is likely at the same time to cut back the amount of goods produced and offered for sale. In which case the gap between the amount of goods available and the amount of money chasing them may be little, if any narrowed, and inflation has by no means has ended. This policy structure may take a very long time to eliminate excess money chasing after goods, but at the same time it is an extremely painful and dangerous to do so in terms of lost production and lives wasted and embittered by unnecessary unemployment19. Concluding Remarks So although the Phillip’s Curve still being used today to interpret economic data, one can see that the relationship of the rate of unemployment and the rate of inflation does not hold under this theory. As already mentioned above, the institutions which correlated these relationships are on the verge of disintegrating. Moreover, the Phillip’s Curve only charts these relationships but does not by any means explain them. These relationships might hold in the short- run by fixing some conditions, but they certainly do not hold in the long run given the existence of major recession and galloping inflation simultaneously. 1. Benderly, Jason and Burton Zwick (February 1985) Money, Unemployment and Inflation The Review of Economics and Statics Vol. 67, No. 1, pp. 139- 143. 2. Benoit, Emily (October 1975) The Inflation- Unemployment Trade- off, and Full Economic Recovery American Journal of Economics and Sociology Vol. 34, No. 4, pp. 337- 344). 3. Brechling, Frank (February 1973) Wage Inflation and the Structure of Regional Unemployment Journal of Money, Credit and Banking Vol. 5, No. 1, Part 2, pp. 355- 379. 4. Cukierman, Alex and Francesco Lippi (June 1999) Central Bank Independence, Centralization of Wage Bargaining, Inflation and Unemployment: Theory and Some Evidence European Economic Review Vol. 43, No. 7, pp. 1395- 1434. 5. Friedman, Milton (June 1977) Nobel Lecture: Inflation and Unemployment The Journal of Political Economy Vol. 85, No. 3, pp. 451- 472. 6. Holmes, James M. and David J. Smyth (August 1970) The Relationship Between Unemployment and Excess Demand for Labor: An Examination of the Theory of The Phillip’s Curve Economica New Series Vol. 37, No. 147, pp. 311- 315. 7. Lockwood, Ben (August 1997) State- Contingent Inflation Contracts and Unemployment Persistence Journal of Money, Credit an Banking Vol. 29, No. 3, pp. 286- 299. 8. MacRae, Duncan C. (October 1972) The Relationship Between Unemployment and Inflation in the Laffer- Ranson Model The Journal of Business Vol. 45, No. 4, pp. 513- 518. 9. Mankiw, Gregory N. (May 2001) The Inexorable and Mysterious Trade- off between Inflation and Unemployment The Economic Journal Vol. 111, No. 471, pp. C45- C61. 10. Phelps, Edmund S. (August 1967) Phillip’s Curves, Expectations of Inflation and Optimal Unemployment over Time Economica Vol. 34, No. 135, pp. 254- 281. Read More